After the cliff: Roths, munis, diversification

How to prepare your nest egg for a new tax reality

BOSTON (MarketWatch)—Most retirees and those saving for retirement can relax slightly now that Congress has passed the American Taxpayer Relief Act of 2012 or ATRA—the compromise bill designed to avert the fiscal cliff.

Discussion of that law, which President Obama signed late Wednesday, has focused mostly on taxes, many of which will rise for the wealthiest 1% of Americans.

But while 99% of taxpayers have avoided the worst of the fiscal-cliff scenarios, it doesn’t mean they won’t still have work to do to adjust their portfolios and saving strategies to the new reality. The possibility of slower economic growth, reduced entitlement benefits and higher expenses remains a looming challenge for future retirees.

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Many should consider opening Roth IRAs or converting their traditional 401(k)—if they are able—to a Roth 401(k), say experts. And many should consider upping how much they contribute to their retirement accounts, as a way to reduce their current taxable income. (The IRA contribution limit for 2013, for instance, is now $5,500 for those below age 50 and $6,500 for those 50 and older.) Still others should contemplate adding tax-free investments such as municipal bonds to their portfolio.

Tax changes affect mostly the top 1%

To understand the broader impact of the deal on their portfolios, taxpayers first have to grapple with the tax implications. On this front, most retirees and would-be retirees have less reason to worry than they did at the end of 2012, at least in the short term.

“It’s status quo for the vast majority of taxpayers,” said Rande Spiegelman, vice president of financial planning at the Schwab Center for Financial Research. “The highest earners will pay additional taxes, but likely won’t have their retirement prospects materially impacted. The lowest level will likely still enjoy the government entitlements they’ve come to expect.”

ATRA raises taxes on income, dividends and long-term capital gains for households that make more than $450,000 a year and individuals who make more than $400,000. For the wealthiest, dividend income and capital gains will be taxed at a 20% rate, up from 15%, and the true rate will be 23.8% as a new Medicare surcharge on the wealthiest takes effect. (See related story.)

Under the bill, Americans at all income levels would see a two-percentage-point jump in the employee portion of the Social Security payroll tax.

But for income earned below the $400,000/$450,000 threshold, the 2012 rates would be permanently extended. All told, the income and investment tax hikes in 2013 could affect fewer than two million households.

Recession avoided?

Some experts also predicted that the economy would not fall back into a recession in the wake of ATRA, as some feared would happen if there were no deal. “This compromise will not solve the longer-term debt and deficit problems facing the United States,” wrote Gary Thayer, the chief macro strategist at Wells Fargo Advisors. “However, it will prevent major tax increases on most Americans, and will, therefore, likely keep the economy from falling into recession. Continued modest economic growth should give lawmakers more time to address the longer-term issues.”

But just because the short-term outlook seems rosier doesn’t mean that people saving for or living in retirement should rest easy. Here’s some advice experts offered recently in this column, “Retiring on the edge of the fiscal cliff: 10 ways to protect your retirement savings.”

Income tax diversification is key

At a minimum, experts say, retirees and investors will need income-tax diversification. In the face of the continued possibility of rising tax rates, it is going to be more important than ever to have some sources of future income that are not subject to income tax, such as Roth accounts. Having a Roth IRA will let retirees and others shift back and forth between taxable and nontaxable income from year to year, depending on one’s circumstances.

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